# Sensitivity Analysis in Decision Making

A few days back I wrote about the basics of decision making. Next, we will look into Sensitivity analysis.

Sensitivity Analysis examines how our decision might change with different input data.

We will start with our previous example, where a company is trying to launch a product and they have the following options right now.

Let us say

P = Probability of a favourable market i.e. Success

(1-P) = Probability of unfavourable market i.e. failure

Sensitivity Analysis

EMV Prototype 1 = 200000P – 180000(1-P)
= 380000P – 180000

EMV Prototype 2 = 100000P – 20000(1-P)
= 120000P – 20000

EMV Do nothing = 0P – 0(1-P) = 0

Point 1

EMV Do nothing = EMV Prototype 2
0 = 120000P – 20000
P = 20000/120000
P = 0.167

Point 2

EMV Prototype 2 = EMV Prototype 1
120000P – 20000 = 380000P – 180000
P = 160000/260000
P = 0.615

So based on sensitivity analysis we can conclude based on probability of success or favorable market P, that

Do nothing if P < 0.167
Go for prototype 1 if P>=0.167 and P<0.615
Go for Prototype 2 if P>= 0.615

# Decision Making – Fundamentals

What is a good decision?

A good decision is based on logic, consider all available data and possible alternatives, and is obtained through rational analysis of data and alternatives.

Does a good decision always result in favorable outcome?

No. Remember, at times good decisions can fail and bad decisions can be a success.

### Steps in Decision making

1. Clearly define the problem: Do we understand the problem or stuck at symptoms?
2. List the possible alternatives: What options are available? Doing nothing is also an alternative.
3. Identify the possible outcomes (or states of nature): What outcomes are possible for the alternatives figured out in step 2? Identify each outcome, positive or negative.
4. List the payoff or profit of each combination of alternatives and outcomes: Create a matrix for each alternative + outcome combination, and figure out payoff.
5. Select one of the decision theory models
6. Apply the model and make your decision

Let’s say a book company is planning to launch an ebook reader (like Kindle). they have 2 prototypes currently in RnD.

Problem statement: Come up with a ebook reader which can boost sales for ebooks.

• Alternative 1: Launch Prototype 1
• Alternative 2: Launch Prototype 2
• Alternative 3: Do not launch a product

Now say for each alternatives we can have various outcomes

• Huge Success (Sales above 100K in a quarter)
• Moderate Success
• Failure

After this we will analyze each combination of payoffs, for example

Alternative 1 (Prototype 1) + Outcome 1 (Huge Success) = Payoff (Profit 200K, selling 100K readers)

Similarly a matrix is created for each combination possible,.

Before making a decision, one needs to take into account the Risk-taking ability of the person or organization. We can divide risk nature into

• Risk Averese
• Risk Nuetral
• Risk Lovers

Also, the risk appetite will change based on the risk involved, for example, for someone earning 100K, a risk of 1K is low, but when the same risk becomes high when it involves 200K.

In addition, one also needs to take Decision making environment into consideration

Decision making Environments

1. Decision making under certainty: Decision-maker knows with certainty the consequences of every alternative
2. Decision making under uncertainty: decision-maker does not know probabilities of various outcomes
3. Decision-making under risk: Decision-maker knows the probabilities of various outcomes.

In short, when a company needs to make a decision, it will start from a decision under an uncertainty position, and try to move to the decision under risk by associating some probabilities to the outcomes based on past experience or market research. When the probability is straight 1 or 0, it is a decision under certainty, which is almost never possible.

Let’s go back to our previous example, and make it simple with just 2 outcomes, and based on past experience company can predict a 50-50 chance of success or failure.

So considering this a Decision under risk scenario, we use a popular method called Expected Monetary Value, to evaluate the alternatives.

EMV or Expected Monitory Value (alternative i) = (payoff of first outcome) * (probability of first outcome) + (payoff of second outcome) * (probability of second outcome) + ….. +(payoff of Nth outcome) * (probability of Nth outcome)

Going back to our use case, we can say

EMV for prototype 1: (0.5)*(200,000) + (0.5) *(-180,000) = 10,000

EMV for prototype 2: (0.5)*(100,000) + (0.5) *( -20,000)=40,000

EMV for Do nothing: (0.5)*0 + (0.5)*0= 0

So based on our analysis, we can see prototype 2 has the largest EMV and is the best option to go under current circumstances.

Normally one only considers market forces that impact business decisions. But there are some important nonmarket forces like government and society that impact business. Hence, every business needs a market strategy as well as a nonmarket strategy to be successful.

Three institutions for allocation of the resources

• Market (Private Sector): Capitalist system operates on the basis of private property, voluntary exchange, competition, and the profit motive.
• Government (Public Sector): Centralized mechanism in which government provides public services to citizens on the basis of criteria other than the ability to pay.
• Community: Decentralized mechanism for allocating resources where the purpose is to meet certain categories of need rather than to make a profit.

Globalization and De-Globalization

Globalization is a concept when local markets open up for global markets. This impacts the import and export of the country. Whereas in certain cases, the government takes decisions based on National priorities over globalization, giving rise to de-globalization.

Every business has to deal with external and internal environments. Internal factors are straightforward where the business has control over, for example, its policies, production units, etc. The external environment is the one where the business has no or little control like government policies, cultural differences between countries, laws in different countries, and so on.

Business flow: Inputs — > Production — > Outputs

Inputs can be land, labor, raw materials, etc. A lot depends on external factors in this case.

Production is the process of converting the inputs into outputs. This is the firm’s internal environment which it can control.

Outputs are the output generated by a firm in form of products and services, which it needs to supply to other firms, government, end customers, again external factors play a role.

## The Market Economy

The image above shows financial flow in a market economy. In this case, households are engaged with firms by working in them and earning wages, investing in the firm and earning dividends, renting land or resources and getting an income, or directly owning the firms and making profits. Households in turn buy from the firms adding to their income.

Government purchases from firms and adding to revenue. Additionally, Government gets tax from firms and households which adds to its income. The government also gives back to households in terms of various schemes like policies for people below the poverty line.

Firms and households interact with the rest of the world in terms of import and export. this also depends on various government policies.

## Market and Non-Market environments in business

Information about the nonmarket environment is important for any firm. One needs to understand what citizens are thinking about the product, what the media is talking about, what are government policies, what are issues raised by NGOs, and so on. Firms need to engage and form coalitions with these units. Firms need to deal with uncertainty around these factors.

The market environment includes direct interactions between firms, suppliers, and customers that involve voluntary economic transactions.

The nonmarket environment is composed of social, political, and legal arrangements and interactions between the firm and individuals, interest groups, government entities.

## Non Market strategy

In short, senior management for any business needs to understand that business is not only economic agents but also are social and political beings. Firms are impacted by a lot many actors like laws and regulations, social pressure, activism, and public perception. So any business management needs to make sure to form a non-market strategy, along with a market strategy.